LET’S MAKE SOME MONEY! 2: How much will you need? (August 2017 Smart BIZ)

The first investment fundamental is to choose your asset allocation between fixed income assets, lending your money for a contracted rate of interest, and equities, buying a piece of the business where returns are not guaranteed by a contract but we expect to do better over the long term, even if there are more ups and downs along the way.

Forget financial advisor blarney that you can get aggressive returns with conservative investments – there is no free lunch. So we are faced with choosing a trade-off between the long term rate of return expected and volatility year to year. The most conservative asset allocation is 100% fixed income assets like bonds and GICs. Bank GICs and government bonds may produce 1 to 2% annually, which can still be a net loss after inflation and taxes. You can add some “high yield” corporate and foreign bonds and maybe get 3 to 4%. Buying gold or cash under the mattress can be similar investment choices.

A “Conservative” investor may include 25% blue chip dividend paying equities in her portfolio and anticipate an average 6% return, at the risk of modest volatility where returns in any one year may be 3% to 9%, but you are unlikely to lose capital, even on paper.

A “Balanced” investor may go 50 : 50 on fixed income and equity asset allocations expecting 4% on the fixed income and looking for 12% on the equities to average 8% annually, but with greater volatility. If government lowers interest rates, reducing the paper value of your bonds to say 2%, at the same time as there is a market “correction” dropping the market value of your equities by 10%, you could have an annual return that year of 2%. Of course the opposite pattern could see your annual return at 14%.

Now an “Aggressive” investor could reduce their fixed income “cushion” to 25% and expand their equities, perhaps including some foreign and emerging markets, to target an average 10% return, at the risk of a year of negative circumstances causing a loss of 10% one year with a 30% return the next. Very aggressive investor might have 100% of their portfolio invested in equities expecting to average 12%, knowing one year can be a 20% loss while another may be a 40% gain. Let’s sum that up with a little table:

Average Return Expectations at

Different Asset Allocation of Equities

% Equities

Target Returns

Volatility

0%

4%

2 to 6%

25%

6%

3 to 9%

50%

8%

2 to 14%

75%

10%

-10% to 20%

100%

12%

-20 to 40%

There are no guarantees in investments; even a fixed income contract can have risk (remember General Motors defaulting on its bonds?). And these numbers are only order-of-magnitude “ball park” guesses to illustrate the point, likely good for two standard deviations of probability or two thirds of the time. Many equity portfolios lost 50% or more of their value in the 2008/9 crash. Poorly advised investors sold off what they had left and stuck it into “safe” bonds. People who understood how the markets work rode it out and had recovered the paper loss within a year or two. Astute investors saw it as a buying opportunity and increased their equity positions. Of course, that is why you are reading this column, to learn how things work so you can make your own choices.

In order to choose the right asset allocation, you need to know how much you are going to need for your definition of financial independence. I googled financial calculators and the first one up was https://financial-calculators.ca/. Based on current family income and your plans for THE END OF WORK, you budget a need for after tax income of $80,000 or say $6000 a month and an $8000 travel fund. You need to provide for Revenue Canada even in retirement so that will need $10,000 a month or $120,000 year gross before taxes.

The high side of government pensions (CPP and OAS) might give you $20,000 each, and your spouse’s defined benefit pension plan after 20 years of government service will provide $20,000 more. That will leave $60,000 a year to be provided by your investment portfolio. How much capital will you require to meet that income objective? Start with the Investment Income calculator. All these income sources are taxable so assume the $5000 a month is coming from RRSP/RRIF withdrawal. The amount needed in the RRSP to start will be $1,232,258. That amount will preserve the capital and live off the earnings. You could plan to use up the capital through retirement. Starting at age 65, 30 years should be a safe bet. The risk is you may live longer than age 95 but maybe you won’t care anymore. The capital needed then reduces to $947,141. But don’t forget your “final expenses” and third trimester emergency fund (when the risks are also greater). Add $50,000 for those savings and you are still going to need a million dollars to provide the target income for thirty years.

The next question is how much consumption are you going to need to forego now in order to support your target level of consumption after your END OF WORK? That, after all, is what this financial planning stuff is all about, fore-going some expenditure today so you have money after THE END OF WORK. Say you are 35 now; your savings so far have gone into TFSAs that now total $50,000 between you and your partner, a reasonable emergency fund. How much are you going to need to invest now in your private “pension” plan to provide the after tax net income you have decided is your definition of financial independence? Your spouse’s pension deductions are $200 a month, matched by employer, so call it $400 a month needed to match that for you who has no pension plan. You have been putting $400 a month into your TFSAs the past few years so this amount is affordable without giving up too much. As this is your pension we are talking about, you think you should be fairly conservative and use the “Conservative” asset allocation of only 25% equities and 75% in a “secure” fixed income bond fund, averaging a 6% annual return but with low volatility year to year; sort of like a set it and forget it approach. In 30 years your pension plan will be worth $391,703. WHOA! But I need a million!

What are your choices? First, that $400 a month into TFSAs was after tax; with tax sheltering in an RRSP, that $400 net would be $600 before tax. Then the capital would be $587,554, better, but still far short of you goal.

Have another look at your asset allocation; consider the “Balanced” approach of 50:50 with 8% average return target. That would provide $850,568. Getting more aggressive, with 75% equities, could get you to the ideal $1,247,526 amount. On the other hand, you are really not comfortable with 75% equities and want to go no further than 50:50. You could add $100 to your monthly contribution, after all it is only $60 net after tax; you could find that in your budget. Now you can project $992,329, maybe close enough?

And asset allocation or portfolio balance choices are not cast in stone. It might be reasonable to go with the aggressive 75% equities while you are young and have a long horizon, with the idea of shifting the balance to 50% for the last ten years.

The whole point of this column is that you need to crunch the numbers for yourself. Do not think you can pick a number out of the air (but $400 a month sounded like a lot!) Know what you will really need, then you can make the trade-offs between asset allocation or risk levels and making larger contributions. There is no guarantee that the $700 a month before tax is going to reach your million dollar target. But putting in less in a more conservative mix is guaranteed to not achieve your target. You can decide to drive the old car longer, to remodel the house instead of buying bigger, cut back from dinner out once a week to once a month. And if you are already 40 and want to retire at 60, you will likely need to do all three and more. You can forgo some consumption now, or learn to like cat food when you’re 75. You choose.